Dollar Cost Averaging vs Lump Sum Investing (What to Do With a Pile of Cash)

The post Dollar Cost Averaging vs Lump Sum Investing (What to Do With a Pile of Cash) appeared first on Budgets Are Sexy.

A friend of mine just admitted to me a big money problem… She has a little over $200,000 in CASH sitting in her checking account! 😳

Hot dang! That’s a lot of moolah!!!

Some of you might be thinking, “What’s the problem? That’s awesome! I wish I had that much in savings!”…  

Well, the problem is, her money isn’t actually invested in anything. It has wicked earning potential, but needs to be moved somewhere so it can take advantage of compound interest. The longer cash sits in her checking account, the more growth she is missing out on!

How to Invest a Lump Sum of Money

My friend is learning about the stock market slowly and knows she needs to make a big investment decision soon… She is considering one of these two options:

  • Invest the entire $200k lump sum immediately into the stock market. OR…
  • Invest the money slowly over time (dollar cost averaging)

Actually, there’s a third option, which is to do nothing and keep holding cash. But, she’s ruled this option out already (and I’ll address why a little later on). 

For now, let’s compare dollar cost averaging vs lump sum investing, contend the pros and cons, and figure out the best option mathematically for her moving forward.

What Is Lump Sum Investing?

A lump sum investment is a complete, once-off transaction to move all available capital into an investment. In my friend’s case, it would be purchasing $200,000 worth of index funds, all at once.

Benefit: The beauty of a lump sum investment is putting ALL your money to work for you as soon as possible. In general, the earlier you invest everything, the more you make in the long run.

Risk: But, moving large sums of money is extremely scary! My friend keeps hearing that “the stock market is at an all-time high.” Her fear is that the day after she invests, there will be a big market crash and she will lose a butt-ton of money.

Not only that, my friend has grown emotionally attached to her cash. It took her decades to save up this amount, and every time she logs into her bank account she feels pride, security, and comfort. She believes all those good feelings will go away if the money goes away.

What Is Dollar Cost Averaging?

Dollar cost averaging (dca) is an investment strategy where you divide up your capital into equal amounts and invest it on a regular basis. In my friend’s case, it would look something like: investing $10,000 per month into index funds for 20 months in a row. $10k x 20 = $200k.

Benefit: Dca investing is an awesome strategy for volatile markets. Sometimes stock prices will be up, and sometimes they will be down, but my friend can rest easy knowing that she will be buying at the average price over the 20-month period.

Risk: Emotionally, this can be like peeling off a Band-Aid very slowly. If stock prices decline over the coming months, she’ll feel like her $10k regular investments are being thrown into a black hole. And if the market rises, she’ll be continually wishing she had invested more money earlier on, at lower prices.

Also, even after 10 full months of investing, my friend would still have $100,000 sitting in her checking account. Her ‘problem’ isn’t really solved fast enough.

Is It Better to Dollar Cost Average or Lump Sum Invest?

Anyone got a crystal ball we can borrow to tell us how the stock market will behave in the near future!!? 🤷‍♂️

Well, we can’t predict the future. But we can look back through past stock market data and see how each strategy would have turned out in years prior.

I’m gonna use this online dollar cost averaging vs lump sum calculator to compare both investment strategies. It will run all the math for us based on historical data over the past 150 years, and tell us which strategy works out better most of the time.

There are 3 inputs needed, and here’s what I’m using for my friend’s case:

  1. How much money is being invested: ($200,000)
  2. How many months if we did a dollar cost averaging strategy: (20 months)
  3. Total amount of years the money will stay invested: (20 years invested this is how long my friend says she has until retirement)

Here are the results:

Out of all the scenarios computed, using 150 years worth of stock market highs and lows, it shows that lump sum investing has been the better option 72.2% of the time.

Not just that, the lump sum strategy has a higher average performance, and higher best performance for the ending portfolio value.

Also, playing around with the calculator, I modified the inputs for the total amount of years invested. Instead of 20 years, I tried lowering to 15, 10, 5, and 2 years… No matter how short or long the investment timeframe, the lump sum investing strategy always has won more than 70% of the time.

Based on this, the investment advice I’d give my friend is: You’ve got a higher likelihood of success dropping your $200k into index funds in one swift transaction.

Your Paycheck: Keep Dollar Cost Averaging!

Quick note… Although the lump sum strategy wins for my friend’s scenario, this is only because she has a massive sum of money saved up! Lump sum investing is only for people with lump sums.

For most regular people, dollar cost averaging is the best strategy with your regular paycheck. If you’re already a dca investor, keep doing what you’re already doing. (If you’re invested in a workplace retirement savings plan like a 401(k), you’re already doing dca — you contribute to the plan every month, and the money gets invested for you every month!)

Should You Wait to Invest Until the Market Crashes?

We’ve determined that my friend should be a lump sum investor, so now the next question is when should she do this?

At the beginning I mentioned a strategy of doing nothing, keep holding cash, and waiting a bit longer until a big opportunity presents itself. But, there are a few issues with waiting for a market crash.

First, there’s been extensive research about trying to “time the market.” It’s almost impossible to predict market timing, especially for a novice investor.

Next, my friend has already been doing this “waiting” strategy for years. Which is proof that it’s not working! Last year in March when the market crashed she was presented with a HUGE opportunity to buy the dip. She wasn’t comfortable investing then, so what’s to say she’ll actually take action next time the market crashes?

All this said, probably the best option for my friend is to invest as soon as possible. Right meow. 🙀

Other Things to Consider When You Have a Lump Sum of Cash

I’m guessing my friend’s not the only one out there with a large checking account balance. Sometimes money comes unexpectedly, like receiving an inheritance, big bonus check, or maybe even a large tax return check.

Before putting all your money in the stock market, here’s a few other things to consider:

  • Got any debt to pay down? Using cash to pay off loans is always a safe move. Your chances of getting a return on your money is 100%. 
  • Double-check your emergency funds: I’ve been using round numbers in my friend’s scenario, but in reality she should leave enough cash left over for her personal emergency fund.
  • Upcoming big purchases, like real estate? If you already have a plan *in the near term* for spending a lump sum, it’s totally fine that it sits in cash for a while! For my buddy, she’s not buying a house anytime soon.
  • Check your risk tolerance! While I think it’s smart to venture outside of your comfort zone once in a while, I don’t recommend making big investing moves that cause extreme stress!
  • Try a blended lump sum & dca strategy: My friend might feel better investing $100k as a lump sum and then the other $100k monthly over a couple years. She can then have a little of both strategy benefits.
  • Chat to a financial advisor: Never hurts to have a professional look at your overall portfolio, asset allocation, investment goals and introduce less risky assets to combat market volatility. 

Have You Helped a Friend Invest?

Figuring out a strategy is only solving 50% of the problem. The other 50% is actually implementing it.

Will my friend pull the trigger and make a $200,000 trade next week? 🤷‍♂️  I don’t know. It’s kind of on her now to make the decision. I can only support and encourage the best I know how!

Maybe you know someone in the same boat? Maybe you’ve been in a similar situation in the past? How would you help and encourage them?

The post Dollar Cost Averaging vs Lump Sum Investing (What to Do With a Pile of Cash) appeared first on Budgets Are Sexy.

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